Top 10 Financial Ratios

Summary

This video covers the top ten financial ratios tested on finance and accounting exams. It explains how each ratio is calculated, what it measures, and how to interpret the ratio. Key ratios covered include days sales outstanding, return on assets, return on equity, inventory turnover, debt-to-equity ratio, times interest earned ratio, gross margin, earnings per share, price-to-earnings ratio, and current ratio. Together these ratios assess company liquidity, leverage, efficiency, and profitability from the perspective of management, investors, and creditors.

Takeaways

• 😀 Days Sales Outstanding measures how quickly a company collects payment from customers. Lower ratio means better liquidity.
• 😎 Return on Assets ratio evaluates how efficiently a company uses its assets to generate profits. Higher ratio is better.
• 💰 Return on Equity ratio gauges profits generated from shareholders' investments. Higher ratio signals effective use of capital.
• 📈 Inventory Turnover ratio indicates how fast inventory sells. Higher turnover implies good inventory management.
• 🏦 Debt-to-Equity ratio compares debt financing to equity financing. Higher leverage increases risks and reduces flexibility.
• 💸 Times Interest Earned ratio measures a company's ability to meet debt obligations. Higher ratio indicates more financial security.
• 🤑 Gross Margin ratio shows profitability after deducting production costs. Higher margin allows more flexibility in operations.
• 💲 Earnings per Share indicates net profits attributable to each outstanding share. Useful metric for evaluating investments.
• 📉 P/E ratio compares share price to earnings per share. Higher ratio signals expectations of earnings growth.
• 🚨 Current ratio evaluates short-term liquidity and the ability to pay off short-term liabilities. Higher ratio is better.

Q & A

What does the days sales outstanding ratio measure?

The days sales outstanding ratio measures the average number of days it takes customers to pay back the business for products or services. It shows how well the company collects payment from customers.

How is return on assets calculated?

Return on assets is calculated by taking the company's net income and dividing it by the average total assets. It shows how much profit is being generated from the assets invested in the business.

What does a high inventory turnover ratio indicate?

A high inventory turnover ratio indicates that a company's inventory is being sold quickly and converted into cash efficiently. It shows effective inventory management.

What does the debt to equity ratio assess?

The debt to equity ratio assesses the degree of financial leverage being used by a company. It shows how much debt is being used to finance operations compared to the amount of shareholder equity invested.

Why is gross margin ratio important?

The gross margin ratio shows how profitable a company's sales are after accounting for the direct costs associated with production. It assesses how much flexibility a company has to cover operating expenses.

What does earnings per share indicate?

Earnings per share shows how much net income is earned per outstanding common share stock. It helps investors evaluate profitability on a per share basis.

How can you interpret a company's P/E ratio?

A high P/E ratio generally indicates investors have strong growth expectations for future earnings. A low P/E suggests poor prospects or slower growth.

What does the current ratio measure?

The current ratio measures a company's ability to pay off short-term liabilities with its current assets. It evaluates liquidity and the ability to manage debt.

What is a good current ratio number?

A current ratio of 1.5-3 is considered good. Less than 1 indicates potential trouble meeting obligations, while higher can mean inefficiency.

What are limitations of financial ratios?

Limitations include variations in accounting methods between companies, use of estimates, and not showing qualitative factors influencing performance.

Outlines

00:00

😊 Intro to Top 10 Financial Ratios

The opening paragraph introduces the top 10 financial ratios commonly tested in finance and accounting exams. It mentions the goal is providing help on exam prep from Passing Score Finance and then previews starting with the #10 ratio - Days Sales Outstanding.

05:01

👍 #10 Days Sales Outstanding Ratio

Paragraph explains Days Sales Outstanding ratio calculates average time to collect accounts receivable. A lower number indicates better liquidity and cash management. The formula is shown taking revenue, accounts receivable, and days in the year to determine turnover rate and days to collect.

10:01

💰 #9 Return on Assets Ratio

This ratio measures the profit generated from the firm's assets, indicating how well assets are managed to produce returns. A higher number is better. The calculation uses net income divided by average total assets. Return on assets can also factor in net profit margin and asset turnover.

📈 #8 Return on Equity Ratio

Similar to return on assets, this measures shareholder investment returns generated by management. The goal is $1 of net income for every $1 of equity invested. It is calculated by taking net income minus preferred dividends over shareholder equity. The components can be analyzed to understand high or low returns.

🏬 #7 Inventory Turnover Ratio

This ratio measures how quickly inventory sells during a period. Faster turnover indicates better liquidity and working capital management. The calculation is cost of goods sold over average inventory level. A higher number is better, but depends on the industry.

🏦 #6 Debt to Equity Ratio

This leverage ratio indicates risks from debt financing. A higher number means more leverage and less borrowing capacity flexibility. It is calculated by total debt over total equity. Some debt can increase returns but too much increases risk.

💸 #5 Times Interest Earned Ratio

This ratio measures the firm's capacity to make required debt payments. A higher number indicates more financial security and income cushion for making interest expenses. It is calculated by earnings before interest and taxes over interest expense.

🛍️ #4 Gross Margin Ratio

This profitability ratio shows revenue remaining after cost of goods sold to cover operating expenses. A higher margin allows more flexibility. It is calculated by gross margin dollars over net sales. Gross margin is net sales minus cost of goods sold.

💱 #3 Earnings Per Share

This key investor ratio indicates profit allocated to each outstanding share of stock. A higher and stable number is better. Manipulation is possible through accounting choices. It is net income minus preferred dividends over weighted average common shares outstanding.

📉 #2 Price to Earnings Ratio

This compares earnings per share to the actual market price per share as a valuation measure. A higher number signals expectations for earnings growth. It is calculated by taking share price over earnings per share.

💧 #1 Current Ratio

The current ratio measures short-term liquidity and the ability to cover liabilities due within one year. A higher number provides a buffer and signals better liquidity management. It is calculated by current assets over current liabilities.

Keywords

💡Financial ratios

Financial ratios are metrics used to evaluate a company's financial health and performance. They are important for analyzing and benchmarking companies. The video covers the top 10 financial ratios tested on finance and accounting exams. Examples from the script include return on assets, return on equity, debt-to-equity ratio, etc.

💡Liquidity

Liquidity refers to how easily an asset can be converted into cash without significant loss in value. The current ratio and days sales outstanding ratio measure a company's liquidity. A high liquidity ratio indicates the company can readily meet short-term obligations.

💡Leverage

Leverage refers to the use of debt to fund operations and growth. The debt-to-equity ratio measures leverage. High leverage can increase returns but also risk. Companies need to balance leverage based on their industry and growth stage.

💡Profitability

Profitability refers to a company's ability to generate earnings relative to revenue or assets/equity. Key profitability ratios include gross margin, return on assets, return on equity. These gauge how efficiently management uses resources to drive profits.

💡Working capital management

Managing short-term assets like inventory and accounts receivable to fund operations. Inventory turnover and days sales outstanding measure how well firms are converting assets to cash.

💡Shareholder value

Maximizing value for shareholders through returns on stock investment. Key metrics are return on equity and earnings per share. High returns and earnings allow firms to attract investors and grow.

💡Debt service coverage

The ability to meet debt obligations. The times interest earned ratio specifically measures if a firm's earnings can cover interest expenses.

💡Operating efficiency

How well a company manages assets and expenses to drive profits. Inventory turnover, return on assets and gross margin measure operating efficiency from different angles.

💡Cash flow

Although not directly measured, liquidity and working capital ratios indicate cash flow efficiency. Firms need to convert assets to cash to fund operations and growth.

💡Benchmarking

Comparing financial ratios against industry averages and peers to gauge relative performance. Examples include p/e ratio, return on equity and gross margin.

Highlights

Days sales outstanding measures how long it takes to collect payment from customers

Return on assets measures the profit generated from the company's assets

Return on equity measures return on shareholder investments

Inventory turnover measures how quickly inventory is sold

Debt to equity ratio measures financial leverage and borrowing capacity

Times interest earned ratio measures the company's ability to make debt payments

Gross margin ratio measures profitability on sales

Earnings per share measures profit per outstanding share

P/E ratio compares share price to earnings per share

Current ratio measures short-term liquidity

Lower days sales outstanding indicates faster payment collection

Higher return on assets indicates more efficient use of assets

Higher return on equity indicates better return for shareholders

Higher inventory turnover indicates more liquid inventory

Higher current ratio indicates greater short-term liquidity

Transcripts

hello and welcome to our top ten

financial ratios this is our listing of

the most commonly tested financial

ratios in Finance and Accounting exams

brought to you by passing score where

you can get more help on your exam prep

at passing score finance calm let's

start with number 10 our days sales

outstanding this is the average number

of days it takes our customers to pay us

back for our accounts receivable for

those invoices that we've sent them out

so this answers the question is how well

do we collect from our customers how

able are we to get our money back and

how are we managing our liquidity as

well the lower the ratio the better it

means that we're collecting our money

quickly and not having to use as much

operating cash or tie up funds in our

accounts receivable this is calculated

first by getting our receivables

turnover our revenue divided by our

average accounts receivable in this case

if our revenue was 850,000 and our

average receivable was 45,000 we would

have 18.9 or almost 19 times turning

over those accounts receivable this then

goes into our day sales outstanding

formula we take the days in the year and

divide by our receivables turnover of

18.9 to get 19 point 3 days on average

it took us to collect our money this can

also be calculated by taking our

accounts receivable and dividing by our

net credit sales which would have to be

kept track of separately in our

financial statements and multiplying by

365 but we should get the same answer

number 9 on our list is return on assets

a key indicator for how well the firm is

managing the investments made by the

company its the profit generated by the

firm's assets

and so we're asking what is the return

that we're getting so the higher the

number the better our ROA is calculated

by taking the net income and dividing by

our average total assets so in this case

128 thousand divided by 895 thousand of

assets means that we were getting a four

point fourteen point three percent

return which is pretty strong ROA can

also be calculated by taking our net

profit margin times asset turnover of

the firm number eight on our list is

return on equity so in this case similar

to ROA we're looking at the return but

on the shareholder investment not on the

total assets so we want to know how is

management management making use of the

investment the equity that I'm providing

to the firm and how much income is

actually generated for every dollar of

income that I get every dollar of

investment that I make an ROI of one

means that I'm going to make one dollar

of net income for every dollar of equity

invested in the firm and we calculate

this by taking our net income minus

preferred dividends we're looking at

common shareholder amounts and dividing

by our shareholder equity so in this

case we have 1.2 million of net income

minus 150 thousand dollars of preferred

dividend payments and dividing by 5.8

million dollars of equity to get an 18%

roee again a pretty strong number roee

can be broken down so that we can look

at the components and see what's

contributing to a strong or weak our OE

number we can take our net income

divided by sales our sales divided by

assets and our assets divided by equity

together to get to our our OE and we can

see in there the components that are

making up either a strong or weak number

and why number 7 on our list is

inventory turnover a key figure for

manufacture

and retail businesses it's the number of

times that our inventory gets turned

over or sold during a period so we want

to look at how this is looking at how

well is inventory managed is it sitting

on the shelves too long or is it getting

turned over quickly used and converted

into cash quickly which is tying in to

how liquid is the inventory of the firm

and the higher the turnover ratio the

better the more that we're selling off

the inventory and turning it into cash

over and over again the calculation is

the cost of goods sold the amount that

we're paying for our inventory divided

by our average inventory level in this

case a turnover of 3.8 means that our

inventory is sitting for almost three

months at a time which may be good for a

large manufacturing or construction

something like that but not very good

for something like retail number six on

our list is a debt to equity ratio so

here we're looking at the leverage of

the firm how much debts they're using to

get their results so a key question this

answers is how much leverage risk is

there is their debt to equity high or

low compared to peers in their industry

and how much could the firm borrow if

they need to if they have a very high

debt to equity ratio they might not have

as many people willing to lend to them

if they need additional cash some debt

is reasonable acceptable can actually

increase the return to the shareholders

but after a certain level the risk just

gets too high and it decreases the

flexibility of the firm to operate our

debt to equity is simply taking our

total debt or liabilities on the

financials divided by our total equity

in this case we get a 1.8 which means

that we have a dollar and 80 cents of

debt for every $1 of equity that we have

in the firm number five on our list is

the times interest earned the amount of

income available to make debt payments

in terms of how many times could we make

those debt payments so how financially

secure is the firm and how many times

could does the MIT there's a firm ache

debt income above its debt payments so

the higher the ratio the more

financially secure is the firm in this

case we take our earnings before

interest in taxes divided by our

interest expense in this case we have an

eleven point eight which is a very

strong ratio number four on our list is

gross margin the ratio of our cost of

goods sold to our net sales and so we're

looking at how profitable is it when we

sell in inventory and how much is

available beyond our cost of goods sold

to pay for operating expenses again a

key for the flexibility as well as the

profit profitability of the firm so we

get a higher ratio by decreasing or

reducing our cost of goods sold our

inputs and increasing our sales price if

we're able to maintain a high margin

high sales prices we're in pretty good

shape so we calculate this by taking our

gross margin in dollars and dividing by

our net sales in this case 718 million

divided by 1.2 billion would be a 60%

gross margin ratio which in most

industries would be very strong our

gross margin in the calculation is

taking the net sales minus cost of goods

sold

that's our gross margin and our net

sales as the gross sales less returns

and refunds so the amount that we

actually get to keep after everybody's

had a chance to return or refund our

product number three in our list is

earnings per share a key indicator for

investors it's the net income divided by

the number of shares outstanding in the

market and this is looking at how much

profit is there for shareholders in

their earnings and if you look at the

history of the earnings per share how

stable is the net income for my

perspective investment in this company

the higher the number the better but

there can be a lot of manipulation or

accounting issues that could obscure the

numbers so it's not always clear because

of the accounting what's going on if we

look at our calculation we take our net

income

again this is accounting income not

economic value or cash flow and minus

preferred dividends again we're looking

at the common shares and dividing by the

weighted average common shares

outstanding so on average how many

common shares were there in this case we

get 66 cents per share which would be

strong or weak depends on how much the

share price is so let's take a look at

that comparison in number two our p/e

ratio are very commonly used a financial

ratio not just in the exams but in the

financial press and in evaluating

companies it's a comparison of those

earnings that we saw to the actual

market share price that's being traded

out there so it's looking at how is the

market value in the stock are they do

they see strong prospects stable or

weakening and how many times earnings

should I pay for this stock is this a

growth company or is this strong

compared to the industry or weak it

depends on one thing you can look at is

the p/e ratio a lower number indicates

that there's poor or flat prospects

while a higher p/e ratio means there's

expectations that there's a strong

earnings growth in the firm a p/e ratio

is taking the market share price what's

being traded and dividing by the

earnings per share we calculated in

number three so in this case we'll have

a twelve dollar share price divided by

four dollars and 87 cents of earnings

per share would get us a p/e ratio of

two point four six which would not be

very strong

and finally number one our most commonly

used financial ratio is a current ratio

it's the ability of the firm to meet its

short-term obligation in this case

short-term is anything that would mature

or come due within one year so we're

looking at how liquid are the firm's

assets and can the firm meet its

short-term obligation can you meet their

payments are they looking strong or like

they might need help it's a good

indicator of their liquidity and also

the efficiency of management management

in managing the payments and assets of

the firm a higher is better and implies

ability to manage their debt it doesn't

tell us a lot about the overall debt

structure of the firm since we don't see

the long-term debt long-term obligations

which could be huge or insignificant we

take the current assets divided by the

current liabilities and again these are

due or maturing within one year or

expect it to turn into cash in one year

in this case 253 thousand divided by 98

thousand means we could cover our

liabilities about 2.6 times well that's

it for our top ten financial ratios if

you have any questions please feel free

to email me at John at passing score

finance calm and as always good luck on

your exam